7/14/2012 @ 12:02PM730 views

What if...?

I received an e-mail from a very worried reader last week. She had just read an article on Yahoo! France that came within an inch of predicting the end of the world and she was alarmed. The story focused on the likelihood of a severe global recession, resulting from a meltdown in Europe and a hard landing in China. To add to the general gloom, the writer tossed in the possibility of U.S. military intervention in Iran, which would draw in Israel and possibly other countries. The result: a war that would have serious and unpredictable consequences.

“It also states that the strong monetary position of Germany prevents the other nations from boosting their economy by a weak currency which would help exports and jobs to revive Europe. The picture seemed very realistic to me,” she wrote. “Are we too complacent with regards to being hopeful that our economy will survive and the TSX will ever reach its old valuation?” she concluded.

For starters, we need to retain a sense of perspective. People have been predicting various forms of apocalypse forever but somehow we have managed to survive. This time won’t be any different. That does not mean there won’t be some difficult times ahead. There probably will be. But they won’t last forever. They never do.

Let’s consider some “what if?” scenarios and what the likely outcomes would be.

The euro zone breaks up. A chain is as strong as its weakest link and right now that link is Greece. If any country is going to ditch the euro and set off a chain reaction, that’s where it will begin. A return to a devalued drachma and a renunciation of foreign debt have been touted as solutions to the country’s woes by radical politicians and they might yet prevail.

Probability index: 25%. There appears to be a new resolve among European political leaders to maintain the euro zone.

If it happens: There will be severe pressure on the European banking system, exacerbated by a run on deposits in the southern tier countries. A massive bailout would be needed to prevent collapse, similar to what we saw in 2008. The European recession would deepen, affecting the rest of the world in the process. Stock markets would fall, although probably not to the extent of the 2008-09 crash only because we would be starting from a lower base. The recovery time would be at least two to four years, although a major stock market rally would like occur sooner once the selling frenzy subsided (as happened in March 2009).

Where to put money: Cash, bonds, and defensive, dividend-paying U.S. stocks.

Countervailing forces: Despite the grinding austerity the country is enduring, the Greek people voted for a pro-euro government on June 17. Moreover, German Chancellor Angela Merkel is on record as saying her country is determined to keep Greece in the euro zone. The election of François Hollande as President of France in May and his demand for policies that are more attuned to growth could result in a softening of the harsh conditions imposed on the Greeks.

The U.S. economy continues to slow. The latest job creation and manufacturing numbers are anything but encouraging. Concerns are growing that the U.S. growth rate, never robust to begin with, is decelerating more quickly than expected. Economists are reluctant to predict a recession in 2013 but the thought is at the back of everyone’s mind.

Probability index: 40%. There is no strong catalyst to reignite economic growth at this time and the political leadership is lacking.

If it happens: Stock markets would go into a prolonged decline with the downward trend fuelled by each new release of negative statistics. We could see a drop of 25% or more in the major indexes within six to nine months. Foreign markets would take their cue from the U.S. Bond yields would drop as more safe haven seekers fled to U.S. Treasuries. Recovery time: two to three years.

Where to put money: Cash and bonds. Buy stocks when the sell-off appears to have peaked. Buy gold if QE3 is implemented (see below).

Countervailing forces: The Federal Reserve Board is holding a third round of quantitative easing (QE3) in readiness in case the situation gets out of hand. Flooding the economy with currency is not a great long-term policy but it has worked before on a short-term basis by boosting the stock markets and raising confidence levels. The upcoming U.S. elections could also be a factor; the return of a President and Congress who are perceived as being able to work together would be a huge confidence-builder and could result in a major market rally. Also, the strong financial reserves of American corporations could start to be deployed once there is more certainty about the future.

China has a hard landing. The Chinese central bank cut its key lending rate for the second time in a month recently, raising concerns that the country’s economy is in even worse shape than was previously believed. China’s growth rate is still much stronger than that of any Western country but the world has become so dependent on Chinese consumption of goods, services, and raw materials that a significant slowdown would have far-reaching consequences.

Probability index: 40%. The country’s growth rate has reached an unsustainable level and the housing market is a serious concern.

If it happens: World trade would slow down, Asian stock markets would tumble, and other world markets would decline. However, because an economic slowdown does not happen overnight the effects would be spread over several months – in fact, we are feeling them already. Recovery time: 18 months to two years.

Where to put money: Again, cash and bonds. Avoid resource stocks. Buy Asian securities once the sell-off runs its course.

Countervailing forces: China’s leadership will do everything possible to maintain a healthy growth rate. This is a diverse nation that has simmering pockets of unrest at the best of times. The last thing the Communist Party wants to see is massive lay-offs that could lead to serious uprisings in major cities like Shanghai and Beijing.

Wild card: If all three of the above events occur, the result will be far more damaging than any one happening in isolation. In that case, cash and U.S. and Canadian government bonds will be the only refuge.

War with Iran. The Iranian government has repeatedly threatened to block the flow of oil to international markets through the Strait of Hormuz. The U.S. has responded that it will do whatever is necessary to keep the passage open. On July 1, the European Union escalated the situation a notch by imposing a boycott on Iranian oil and saying it will remain in place until Tehran enters into serious negotiations about its nuclear program. Iran quickly branded the move as “malicious” and said it has built up $150 billion in foreign reserves to deal with the situation. Interestingly, it did not reiterate its threat to block the Strait.

Probability index: 20%. Iran knows it cannot win any confrontation with the U.S. Navy over Hormuz. Its fleet of fast boats and destroyers is no match for American fire power. A stinging defeat in the Persian Gulf would give new strength to opposition forces within the country.

If it happens: The price of oil would temporarily soar. Just the possibility of that happening, along with the EU boycott, pushed oil up by about US$10 a barrel. Stock markets could rise if the U.S. scored a quick and decisive victory.

Where to put money: Oil stocks and gold.

Countervailing forces: The leadership in Tehran is ideological and ruthless, but it isn’t crazy. The country has much more to lose by provoking an armed confrontation than it has to gain.

Wild card: Israel. If it uses a clash in the Gulf as a pretext for launching an attack on Iran’s nuclear facilities, all bets are off.

Post Your Comment

Post Your Reply

Forbes writers have the ability to call out member comments they find particularly interesting. Called-out comments are highlighted across the Forbes network. You'll be notified if your comment is called out.